Sept. 26 (Bloomberg) -- Wachovia Corp. and National City Corp. slumped after negotiations on the government's financial bailout stalled and Washington Mutual Inc. was seized by regulators and sold to JPMorgan Chase & Co.

Wachovia dropped $3.84, or 28 percent, to $9.86 at 1:20 p.m. in New York Stock Exchange composite trading, and Cleveland-based National City fell 40 percent. National City and Charlotte, North Carolina-based Wachovia have plunged more than 80 percent in the past 12 months.

``Washington Mutual showed that one of the big ones can go down, and if you are looking at who else in the top 10 is facing the most pressure, Wachovia is right there,'' said Stan Smith, a banking professor at the University of Central Florida in Orlando.

WaMu was taken over by regulators yesterday in the biggest U.S. bank failure after customers of the Seattle-based lender withdrew $16.7 billion from accounts since Sept. 16. The savings and loan was ``unsound,'' the Office of Thrift Supervision said. The collapse came as lawmakers planned to meet again after talks on Treasury Secretary Henry Paulson's bailout reached an impasse.

Fears of mounting losses on Wachovia's $122 billion in option adjustable-rate mortgages helped push the company's shares down by 64 percent this year before today's trading. Chief Executive Officer Robert Steel is treating the loans as distressed debt and named a senior bank official, David Carroll, to lead an effort to minimize losses on option ARMs that the bank expects to total about $14 billion.

`Extremely Valuable'

``We are focused on managing our company and serving our customers with excellence,'' Wachovia spokeswoman Christy Phillips-Brown said. ``Our core franchises -- retail banking, the nation's third largest brokerage firm, wealth management and our commercial and corporate banking activities -- are extremely valuable and continue to operate well relative to our competition.''

In addition to its option adjustable-rate mortgages Wachovia had $45 billion in more traditional mortgages as of June 30. That total of $167 billion ranks second among U.S. lenders behind Bank of America Corp.'s $239 billion, followed by Citigroup Inc.'s $145 billion, according to an Oppenheimer & Co. report.

``All eyes are now on Wachovia,'' said Anton Schutz, president of Mendon Capital Advisors Corp. in Rochester, New York.

Option-ARM Mortgages

Wachovia became the largest option-ARM seller through its $24 billion acquisition in 2006 of Golden West Financial Corp., the Oakland, California-based lender that popularized the product over the previous 30 years. Wachovia expects cumulative losses of about 11 percent to 12 percent on its option-ARM loans.

``We feel it is likely that Wachovia will need to issue equity to provide greater reassurance about its liquidity and solvency,'' Mike Mayo, an analyst at Deutsche Bank AG, wrote in a note today. He reduced his target price to $11 from $16 a share.

Mayo expects the firm will need an additional $11 billion in capital assuming a 20 percent discount on their ARM portfolio, he wrote. Assuming common shares were issued at yesterday's closing price, it would dilute current shareholders by about one third.

Merrill Lynch & Co. analyst Edward Najarian expects the losses to be in the 15 percent to 17 percent range, according to a Sept. 9 report. Housing prices in California declined by a record 41 percent in August, the 11th straight monthly fall, the California Association of Realtors said yesterday. Almost half of Wachovia's option ARMs are in California.

Option ARMs allow borrowers to skip part of their payment and add that sum to their principal. Monthly costs eventually increase after introductory interest rates as low as 1 percent.

Bailout

Because typical option-ARM borrowers make less than the full payment each month, according to Fitch Ratings, they don't build equity in their homes. When house prices fall, borrowers often owe more than their homes are worth. That leaves lenders facing losses if the borrower defaults.

``A bailout plan needs to be approved as credit markets have frozen, credit spreads have widened and it's getting more difficult for businesses and consumers to get access to credit,'' said BMO Capital Markets analyst Peter Winter in a note to investors today.

Wachovia's shares advanced last week on speculation it would be a beneficiary of the Treasury's rescue plan. The company's option ARMs may be simpler to sell to the government than securitized pools of loans, said Kevin Stein, associate director of the California Reinvestment Coalition, a San Francisco-based nonprofit.

Wachovia holds the loans on its balance sheet, while WaMu and other big option-ARM lenders pooled the loans into securities that were sold to investors, he said.

Must `Unload' Portfolio

``If Wachovia could unload a third or a half of its option- ARM portfolio without taking a major hit to earnings, that would be a very positive development,'' said Gerard Cassidy, an analyst at RBC Capital Management in Portland, Maine. ``Whole loans are a lot easier for the government to buy than CDOs or CDO squared,'' he said, referring to collateralized debt obligations.

At the time of its failure, WaMu had $28.4 billion in outstanding bonds, with Capital Research and Management the largest debt-holder, Bloomberg data show. All three major credit agencies rate WaMu junk, the only company in the 24-member KBW Bank Index that's below investment grade.

Wachovia has investment-grade ratings from Moody's Investors Service, Standard & Poor's Corp. and Fitch. Moody's and Fitch have a negative outlook on the lender, indicating a possible downgrade.

During the past three quarters, WaMu lost $6.3 billion. It kept skidding even after joining a list of financial companies the U.S. Securities and Exchange Commission protected from short selling in an effort to stabilize stock markets.

To contact the reporters on this story: Linda Shen in New York at lshen21@bloomberg.net; David Mildenberg in Charlotte at dmildenberg@bloomberg.net

Last Updated: September 26, 2008 13:38 EDT